June 29, 2016
Brexit - We are on the Case
Brexit, the nonbinding referendum calling for Britain’s departure from the European Union is behind us, but the uncertainty surrounding it will continue. Prime Minister David Cameron has announced his resignation, but will likely stay on until October, when a new Prime Minister will be selected by Cameron's Conservative Party. Negotiation over departure terms may begin now or not until the new PM is in place. After negotiations are complete, the agreement will need to be ratified by Parliament. That may prove to be particularly difficult given that "Leave" voters carried the day with such a slim majority (51.9% v 48.1%). Some even believe that “Remain” voters can rally enough support to force a second referendum.
If negotiation and ratification can be achieved by January of 2017, for example, actual departure may come as long as 2 years later in 2019. Meanwhile the Remain camp continues to promote a list of doomsday scenarios including everything from an economic recession to the break-up of the United Kingdom. Conversely, "Leave" enthusiasts can be just as persuasive. Matt Ridley, best-selling author of The Rational Optimist and a member of the House of Lords, penned a concise argument The Business Case for Brexit in last week’s Wall Street Journal.
Although the referendum is over, the controversy over Brexit is just beginning. Continued uncertainty is likely to weaken British and European economies which may then dampen global growth. This comes at a time when global growth is already weak and central bankers around the world are doing everything they can to stimulate it. The key point here is that the real problem is uncertainty. The United Kingdom is a sovereign democratic nation and UK voters get to determine their own economic affiliations. The consequences of their decisions will play out over time and, importantly, market prices will reflect whether those decisions were wise or unwise. No one knows yet. What we do know is that we are in a low return environment that is likely to continue. Why does that matter?
Interest rates are the “price” of money, and we investors are in the money business. That is, we provide our capital to be used by others. In the case of bonds, we are paid an interest rate. In the case of stocks, we are paid with a claim on a portion of a company’s earnings and, sometimes, a dividend. But, in either case, we are in the business of charging for money. When the largest providers of money in the world (central banks) give it away for free, that can’t be good for our “business.” Historically low central bank interest rates are the source of this low return environment which will persist until stronger economic activity justifies higher rates.
So uncertainty and controversy over Brexit must be viewed in the context of weak global growth and a low return environment. Markets will absorb that controversy and work their way to an equilibrium price that compensates investors for residual uncertainty. Today, the best independent money management experts in the world are using massive computing capability to power through income statements in an effort to determine which UK companies are likely to be hurt by Brexit and which will be helped by, for example, a weaker British Pound. The same is true for stocks throughout Europe and across the globe. Which German companies export into the UK and will their sales suffer? Which French companies will benefit if British sales into the Eurozone weaken? Many of those independent experts work on your behalf through Hirtle Callaghan.
Beyond stock picking, in markets with these kinds of complex, global crosscurrents, a powerfully logical philosophical anchor is absolutely essential. Our powerful, philosophical anchor is relative cash flow. History and, much more importantly, logic tell us that serious investing is entirely about acquiring future cash streams at the most attractive rate. Everything else, in our view, is more or less noise communicating confusion rather than a clear, consistent path forward.
Strategically, we know that global stocks are priced to produce the kinds of returns that our clients require; bonds are not. Consequently, we will continue to overweight global stocks. Within global stocks, while we know the US is the best place in the world to do business, international stocks are priced to produce higher returns over the next 3 to 5 years. Consequently, we will remain marginally overweight to international. At the same time, the emotions associated with Brexit will inevitably lead to mispricings and we are on the lookout for special situations to add to the mix.
In this low return environment, serious investors have 2 logical choices. The first is to stay away from stocks and wait. With inflation close to 2% and US Treasury interest rates ranging from ½% at 1 year to 1½% at 10 years, investing in low volatility US Treasury notes will deteriorate real purchasing power over time, and there are no higher interest rates in sight, but it does avoid most volatility. The second logical choice is to overweight global stocks because they are priced to return 6% to 10% over the next 3 to 5 years. Those levels of return will enhance wealth after inflation, spending and even taxes, but they can be accompanied by tremendous short-term volatility.
What we are experiencing in the aftermath of Brexit is what short-term equity market volatility looks and feels like. And there is more to come. It’s not that stock markets are likely to be more volatile than average, it’s that bonds, the portion of the portfolio normally relied upon to provide ballast and dampen volatility, have been rendered almost unusable by historically low and even negative interest rates. Paraphrasing Thomas Paine, these are the times that try long-term investors’ souls.
It's going to be an interesting summer and we are on the case.
Thank you for your trust and confidence,
Jonathan J. Hirtle
Jon is the Chairman & CEO of Hirtle Callaghan. He also chairs the Executive Committee and serves on the Investment Policy Committee. Prior to founding Hirtle Callaghan in 1988, Jon worked at Goldman, Sachs & Co. advising family groups and institutions on investment strategy and securities selection. He received his Bachelor of Science and M.B.A. degrees from the Pennsylvania State University. Jon served as an officer in the United States Marine Corps from 1975 to 1982 and is a member of the Governing Council of the Miller Center for Public Affairs at the University of Virginia.